Citi Sours On Lowest-Rated Junk Bonds

By Michael Aneiro

Count Citi among the skeptics who think junk-bond valuations are getting too lofty, as Citi downgrades its view on the lowest tier of junk, cutting triple-C bonds to underweight and recommendomg investors either position more defensively by accepting a lower yield or look elsewhere:

At this point in the cycle, we believe investors should underweight the triple-C universe. In September 2012, we recommended an overweight to low-quality bonds, a position we held deep into 2013. We began 2014 with a neutral rating. Now, however, we lower the rating to underweight and suggest investors continue to focus on single-B credits. To be sure, there are underrated triple-C issuers that are of similar quality to single-B companies but as a whole, we recommend reducing triple-C exposure.

Citi credit strategists Michael Anderson, Angel Jua and Lina Lavitsky walk us through a little high-yield history to highlight that this current Fed-fueled credit cycle doesn’t look like past cycles:

Prior to the current cycle, triple-C bonds generally performed roughly in line with the market over the course of a cycle (i.e. peak to peak). In other words, the default drag was significant enough to offset any additional yield the rating segment offered. Combined with greater credit risk and higher volatility, some investors naturally questioned the importance of holding a significant triple-C allocation through the cycle.

The current cycle, however, has been quite different. Since the pre-crisis in May 2007, the CCC-Rated Index has returned 44% more than the High Yield Market Index. Even when including the steep losses suffered during the crisis and the Treasury rally which should have benefited higher-quality assets more, triple-C returns have been far superior since 2007.

Citi says the biggest risk to its underweight call is that it might be too early, as junk bonds maintain pretty strong momentum, but cites four pillars supporting its view:

We downgrade triple-C to sell from neutral based on four factors: high negative convexity, inevitable defaults that are difficult to offset given lofty valuations, crowded positioning, and significant yield compression to higher-quality paper. If we are correct that most of the triple-C outperformance is behind us, it caps one of the best runs in the history of the asset class. The current cycle’s success was driven by a unique combination of factors which are unlikely to be repeated in future cycles. Our analysis highlights, however, the degree to which cycles are unique and how that affects relative performance across the quality spectrum. The evolution of the cycle (i.e. speed and magnitude) plays a central role.

The latest check on the Bank of America Merrill Lynch high-yield index shows CCC-rated bonds yielding 8.4%, versus 5.2% for the entire high-yield market, with both returning 3.26% so far this year.

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